Oil, the Dollar and the Election

Last week, the Fed's ‘twist action’ was extended. Make no mistake, commodity prices will be affected

The price of crude oil has fallen in recent months. As a result, gasoline prices have followed suit, giving a welcome relief to travelers and just in time for the summer vacation season. What's behind this recent move?

Commodity prices are driven by two major factors: the value of the dollar and supply/demand dynamics. The recent drop is no different. In fact, the correlation between the dollar and the price of oil is -0.74, indicating a strong negative relationship. As the dollar has been strengthening lately, oil prices have relaxed.

Why is the dollar strengthening you may ask? After the Troubled Asset Relief Program, the Federal Reserve embarked on a second round of quantitative easing in an effort to foster inflation and quash deflation by making money more available and cheaper, with the hope that consumers and businesses would borrow. However, these two important groups remained cautious in their spending, and the bulk of this stimulus still sits at the Federal Reserve banks.

Then, the Fed began Operation Twist. In short, the Fed sold short-term government securities and bought longer-term issues. This action put downward pressure on long-term interest rates, which made it cheaper for the government and homeowners to borrow.

Last week, this “twist action” was extended. Operation Twist doesn't flood the market with dollars simply because they are using the proceeds from the sale of the short-term securities to buy longer-term bonds. Therefore, the dollar has been strengthening, contributing to the fall in commodity prices.

If the Fed were to introduce QE3, the money supply would be further expanded, and we would see oil and other commodities rise. However, this assumes global demand remained somewhat constant. Demand is the other side of the coin. With Europe in a recession, America's economy slowing, and the BRIC countries, most notably China, slowing, the global economy is getting weaker. This slowdown in global economic activity and the stronger dollar should keep commodity prices, and specifically oil, lower. Of course, a conflict in the Middle East could change all that.

If economic growth does continue to slow to the point where deflation becomes a threat, then the Fed would certainly entertain the idea of another round of QE. In Bernanke's mind, anything is better than deflation, especially since he is such a student of the 20-year Japanese deflation trap. However, if deflation does not appear to be a threat, then QE3 would not see the light of day.

The drop in oil is just in time for the November election. I expect the dollar will continue to strengthen for a little while longer. Rest assured, its movement is not strictly dependent upon market forces. There's another force at work, which is especially true in an election year. One can only hope that change takes on a new meaning in November. 

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